How to Play a Pop in Natural Gas Prices

by Aaron Levitt | January 25, 2012 9:49 am

America’s new love affair with natural gas is having some unintended consequences. Increased drilling activity has created one of the worst supply gluts in history, causing natural gas prices to plummet. Prices have fallen about 23% just since the beginning of 2012 and now sit close to their historic 2002 lows, or around $2.32 per million BTU.

According to the U.S. Energy Information Administration, storage levels for the fuel remain elevated around 21% higher than their five-year averages. To that end, a variety of natural gas producers have begun shifting to more profitable shale oil operations and reducing drilling activity. However, one big producer’s decision this week to lower its output could finally put the spark back into natural gas prices and boost the industry’s profitability.

That producer is Chesapeake Energy (NYSE:CHK[1]), which announced on Monday that it will cut its production[2] and drilling activity. The country’s second-largest producer of the fuel said it would decrease output by 8% throughout 2012. Chesapeake currently is responsible for around 9% of nation’s natural gas.

The overall plan calls for a reduction of around 500 million cubic feet of gas per day across three main drilling regions in Texas, Arkansas and Louisiana. Chesapeake will also drop dry-gas drillings by half as the company approaches the second quarter. In addition, the company said it would be prepared to cut daily output by up to 1 billion cubic feet, if necessary.

While extreme weather of supercold winters and hot summers of the last two years has provided some support for natural gas prices, despite the supply glut, this year’s unseasonable warm winter in the Midwest and Northeast has caused a huge backlog of natural gas supply. Prices per 1,000 cubic feet continue to drop as demand keeps falling.

Most natural gas in the U.S. goes to electricity production. Chesapeake and other major producers have been lobbying for its use as a transportation fuel or for export because international natural gas prices are higher. So far, these efforts have gone nowhere as Congress has failed to help tap the fuel’s real potential. At current prices, only the least expensive and most productive wells produce any sort of profit for the exploration and production (E&P) firms. And despite the recent shift to shale oil, those wells often produce natural gas as well.

Chesapeake’s move is designed to help push natural gas prices upwards, and analysts say other companies will follow suit. Several other firms will also have to cut output[3] to make natural gas economically viable for producers. BNP Paribas energy analyst Teri Viswanath said[4] of the move: “You are going to have to see more than just Chesapeake. For us to balance this market, other producers are going to have to take some serious proactive measures.”

Already some firms have begun the shift. Canada’s Talisman Energy (NYSE:TLM[5]) has announced a sharp cut in rigs drilling in the Marcellus shale region and energy services firm Halliburton (NYSE:HAL[6]) has seen more of its fracking equipment go toward shale oil rather gas over the last few weeks.

Playing the Pricing Push

While the industry still faces a major demand problem, the recent moves by Chesapeake and others could be the start of higher prices. For investors, now could be a great time to add the sector to a portfolio. The United States Natural Gas Fund (NYSE:UNG[7]) has been one of the worst long-term wealth destroyers out there, but it popped 9% on the Chesapeake news. In the short term, the fund might make a good trade because some analysts now predict prices have finally bottomed out. Similarly, ProShares Ultra DJ-UBS Natural Gas (NYSE:BOIL[8]) provides a short-term leveraged option.

For those looking for more of an investment option, the First Trust ISE-Revere Natural Gas ETF (NYSE:FCG[9]) tracks a basket of natural gas E&P firms and could see its fortunes finally rise. Analysts estimate that Chesapeake’s earnings fell to $2.81 per share in 2011, down from $2.95 in 2010, due to lower natural gas prices. So, any price increases will see better earnings from FCG’s constituent holdings, and will benefit shareholders. BNP Paribas’ Viswanath sees prices rising to averaging $2.70 per million Btu in 2012 and $3.85 per BTU in 2013.

Chesapeake’s move could certainly be thought of as a game-changer for natural gas. As the industry standard in the sector, its decision to cut production should help buoy falling natural gas prices. Until the sector’s “under-demand” problem is rectified, more E&P firms will likely join Chesapeake. For investors, playing the resultant near-term pop in prices could be a great move in coming months.